Venture funds brace for worst as cash sits idle

Venture capitalists are still finding some investments worth making, but many are bracing for the worst as the industry deals with its sharpest downturn in a decade.

Although returns are plunging for venture capital funds that fueled the tech boom in the late 1990s, some firms have raised new money and others are still sitting on billions raised in happier times that they have yet to invest.

Updata Venture Partners of Reston, Va., finished raising money for a $67 million fund in the spring of 2001. Since then it has invested about a quarter of the fund in four companies and already sold one of them. Still, Updata has not made a new investment in 14 months.

But Updata's wallet may open again. John Burton, the firm's managing general partner, expects to close a handful of deals in coming months. "We are extremely busy," he said.

ECentury Capital Partners of McLean, Va., closed a $90 million fund last year, and though it has made a dozen investments, it has committed only $12 million and taken four board seats, leaving it ample time and money for new investments.

"A lot of the deals we're seeing tend to be a little later stage," said Thomas Dann, a managing director.

That seems to be one key to making a successful deal lately. Later-stage investments in firms with experienced managers who have real products and customers win the venture capitalists' favor.

"The percentage of qualified management teams is up dramatically," Burton said. "They're working on expanding their business model instead of creating it."

Venture funds in the first quarter invested just $5.1 billion, a 53 percent drop from a year earlier, according to VentureOne Corp., an industry research firm. They raised just $2.25 billion in the first quarter, the lowest amount since 1995.

If you look at a five-year period, venture capitalists made a 35.9 percent return on their investments through the end of 2001, Thomson Financial/Venture Economics reported. But that counts the 3,135 still-surviving start-ups that were funded during the boom years of 1999 and 2000, a large percentage of which are expected to fail.

Venture capitalists at an industry conference said they are bracing for a "traumatic contraction" that could wipe out half of the nation's 800 venture firms in the next few years.

"You can just look at the numbers and see that another day of reckoning is coming," said Peter Barris, managing general partner of New Enterprise Associates' Reston, Va., office. "We are going to have to go through another painful trough."

In 2001, the value of early-stage venture capital funds fell 33.9 percent. That means that $100 invested in an early-stage fund on Jan. 1, 2001, would have been worth $66.10 on Dec. 31. Later-stage venture investments fell 20 percent in the same period. The value of all venture funds fell an average of 27.8 percent, marking the first annual loss recognized in any year since the industry began tracking returns in 1980.

So it's no wonder that venture capitalists are looking for bargains that could net bigger returns if the investments are cashed out.

The costs of expanding a business have dropped, costs that venture-financed companies tend to spend a lot of money on before they make a dime in revenue. Labor costs are starting to come under control, too.

"It's the cheapest time to put together companies from an infrastructure standpoint that you're going to see," said Burton. "Legal fees, accounting fees, recruitment fees, rent--particularly office facilities--there are tremendous values out there."

"The whole thing with venture capital is buying low and selling high and this is a very good time to be buying low," said John Taylor, vice president for research at the National Venture Capital Association.

But venture capitalists earn money by selling companies they invest in to larger companies, or taking them public by selling shares on the stock market. If the seller's market is lousy, the climate for initial public offerings is frigid.